Perspectives matter Protectionism, politics, populism

Tracy McNaughton
Head of Investment Strategy in Australia & New Zealand, UBS Asset Management

Perspectives matter

Despite unprecedented levels of monetary accommodation, economies around the world are still struggling to generate sustainable growth nearly ten years on from the financial crisis.

There have been no fewer than 670 interest rate cuts globally since 2008, around 489 million people now live in countries where the official interest rate is negative, and major central banks have expanded their balance sheets by over USD 12 trillion. But a realization is dawning that economies are hamstrung by structural challenges that cannot be addressed with cyclical tools such as interest rate cuts alone. In particular, the US economy is experiencing its weakest recovery in the post-World War II era (Chart 1).

The US Federal Reserve has now recognized that the decline in the neutral rate, the interest rate that is neither stimulative nor restrictive for the economy, is something that is more than a temporary cyclical, reaction to the financial crisis. Aging populations, slower productivity growth and a reluctance of business to invest have driven potential growth rates lower and hence lowered the neutral level of interest rates.

A decline in the neutral interest rate impairs the effective operation of monetary policy. The lower the

Tracey McNaughton

Tracey McNaughton was appointed Head of Investment Strategy in Australia & New Zealand in October 2013. In this role she has responsibility for Australian economic and investment research and is a member of the Australian Investment Committee.

neutral rate, the more monetary policy must be eased in order to get to an expansionary policy setting. This is why nominal rates have had to go negative in Japan, Europe, Sweden, Switzerland and Denmark, and why there is now USD 13 trillion worth of bonds that have a negative yield (see Chart 2). It is also why Fed Chair Janet Yellen believes the current stance of monetary policy is “only modestly accommodative” despite the federal funds rate sitting at 0.5%.

Monetary policy can boost asset prices but it can do very little to boost an economy’s potential growth rate. For this we need the government to step in with structural reform and productivity-lifting fiscal policy.

Central banking, no longer the only game in town

Governments are beginning to realize that central banks cannot be the only game in town. Three broad determinants of a country’s potential growth are population, productivity, and participation in the labor force. Increasing any or all of these factors will have a positive effect in lifting the potential growth rate of an economy.

Fiscal policy will likely be positive for developed economies’ growth next year for the first time since

2010. Japan and Canada have already announced stimulus programs. Japan’s government announced a supplementary budget worth JPY 28.1 trillion of which JPY 4.7 trillion (0.9% of GDP) is new spending, while the Canadian government has pledged CAD 60 billion of new infrastructure spending over the next decade, double the previously planned amount. The focus for the spending is on public transport, housing and water systems. The UK has indicated it would slow down the pace of fiscal tightening as a result of the expected impact on growth from the Brexit decision in June. In the US, President-elect Trump has proposed tax cuts, infrastructure, defence and health spending. Even in Germany, where an election next year looms large, the government is becoming less austere. The Government has promised USD 7 billion worth of tax cuts in 2018 and announced a EUR 264 billion infrastructure package to be spent on roads, railways, roads and waterways by 2030.

However, more needs to be done. The longer it takes governments to realize that change is necessary, the more difficult it will become to implement that change. Electorates around the world are becoming increasingly dis-enfranchised with their governments and so are gravitating toward minority or fringe parties. The end result is weakened mandates and a depletion in the political capital needed to drive the structural change and reform needed to lift potential economic growth.

Chart 1: Average annual change in US real GDP

Source: US Commerce Department, UBS Asset Management.

Unconventional monetary policy meets unconventional politics

Globalization, free trade, large scale immigration programs, and free market ideologies in general have produced the most rapid progress in living standards that the world has ever seen. Millions have been raised out of poverty. Life expectancy has increased as new technologies are shared. Wealth has been created at a scale that our ancestors could not have imagined.

Given this progress, why is there such discontent? While inequality has fallen across countries, within countries it has increased. For example, the top 1% of earners in the US have received 95% of the growth in income since the crisis. This is compared to an average of 54% for 1979-2007. In 34 of the 83 countries monitored by the IMF, income gaps had widened since 2008, with incomes of the richest 60% rising more quickly than those of the poorest 40%.

The over-reliance on monetary policy since the financial crisis trends has boosted the wealth levels of asset owners (physical and financial) but has done little to boost aggregate demand in the real economy. Meanwhile government policy to address the hollowing out of industries as a result of globalization has been notably absent.

As a result, income and wealth inequality within countries has increased and with it support for antiestablishment political parties whose policies are based more on nationalism, populism, and demagogy. The antithesis of what globalization represents. Support for these non-mainstream parties has meant coalition and minority governments are on the rise around the world. Given the number of significant elections next year in Europe, 2017 will be a defining year for global politics.

Rise in protectionism

What was a tentative tilt away from globalization prior to the election of Donald Trump as US President has now been given a significant push. Political culture is contextual. The euphoric benefits of globalization as China ascended onto the world stage some 15 years ago have given way to the ugly truth for those left
behind by governments who failed to re-train, re-educate, and reform affected industries. This political new normal will require investors to re-price the sovereign risk they take.

From an economic perspective, globalization is the great equalizer, at least across countries if not within. Allowing the free flow of labor and capital means price differentials are bid away, resources are more efficiently distributed and overall welfare is lifted. A move away from globalization means this equalizer will not work as efficiently.

Chart 2: Percentage of global developed market sovereign bonds outstanding by yield to maturity

Source: UBS Investment Bank, Bloomberg. Conventional sovereign bonds weighted by amount outstanding as of November 18, 2016.

It is true the benefits of globalization are not spread evenly within a country. Middle-class wages in the US stopped rising more than 30 years ago. It is here where government policy has a role to play in ensuring those most adversely affected by globalization are not left behind.

In the decades leading up to the financial crisis, the rising tide of strong economic growth globally lifted all boats, obscuring the rise in inequality within countries. After the financial crisis, when the tide was no longer rising, or rose less fast, the relative differences between income and wealth cohorts within countries become more obvious.

Some governments have responded to the political pressure posed by this inequality by raising trade barriers or imposing trade restrictions. According to the Global Trade Alert (GTA), 2015 saw a 40% rise in protectionist activity, the worst outcome since the global financial crisis.

Protecting an industry hardly equates to an efficient use of an economy’s resources and governments have not shown to be very effective in their resource allocation. The UK’s new Conservative Prime Minister, Theresa May, appears to be signalling an end to Britain’s free-market economic liberalism of the past. As a way of responding to the will of the people following the Brexit result, May is implementing an interventionist industry policy to promote certain industries the government deems to have value.

Not only are trade barriers rising, but the number of free trade deals being successfully negotiated is falling. The fate of the most ambitious arrangements, the Trans-Pacific Partnership (agreed, though not ratified) and the Transatlantic Trade and Investment Partnership (very far from agreed), remains quite uncertain.

In a globalized world, inefficiencies are bid away and global collaboration supports the greater good. In a less globalized world, inefficiencies remain and national interests are put first. This must be priced by financial markets accordingly.

In this world, global institutions will need to make way for more regional ones. Trade agreements will become more preferential. Multi-national corporations will shrink and cross-border political collaboration will be more difficult to achieve outside of the region.

In 2017, investors will need to re-price risk to reflect national differences between sovereigns and between regions. From a strategic perspective, this will likely benefit developed markets more than emerging markets. Within emerging markets, however, the fundamentally more sound Asia region will benefit over the less sound Latin America. Between asset classes, more expansionary fiscal policy and more protectionist trade policy suggests bond yields will be pressured higher. This may not be to the detriment of equities, however, if growth supports earnings expansion.

Chart 3: Number of free trade agreements

Source: IMF, UBS Asset Management.